How to assess the risks in your investment portfolio

There are millions of different investments you can buy, and they all require you to think about the same key trade-off: risk versus return.

In general, the higher the potential returns on your investment, the more likely it is that its value will decline sharply. As you look to maximize the return on your portfolio, ask yourself: What would a significant decline in my investment do for me?

The question requires a multifaceted answer – one that looks at how a decline in your portfolio physically affects your money and how you react emotionally to losing money.

Recently, many investors have been able to answer this question directly. The broad stock market plunged nearly 24% between January and mid-June, with many individual stocks and more volatile assets, such as cryptocurrencies, doing much worse.

If the recent market volatility has been hurting a little more than you thought it might, consider taking some time to meditate, says Kristen Benz, director of personal finance and retirement planning at Morningstar.

“A lot of people entered the market in 2020 and 2021 just because it was going up,” Benz tells CNBC Make It. “Now is the time to take a deep breath, step back and think about the appropriate amount of risk you should be taking in your wallet.”

Here’s how to make sure you’re investing with the right level of risk, according to market experts.

Understand the ability to take risks and take risks

Back to the central question: What could a significant drop in the value of your portfolio do to you?

First, a drop in your portfolio will materially affect the rest of your financial picture. This is called your ability to take risks. If you’re away from a long-term goal, such as retirement, short-term declines in your portfolio aren’t necessarily a very big deal because your investments have decades to recover.

If your goal is in the near future, then a big loss may derail your plans. If you had a portion of your portfolio set aside for a down payment on a home this year, for example, you might not be able to afford a 24% drop.

Second, how would a big loss feel to your portfolio? The answer is bad, of course – but how bad is it? “A pessimistic “checking of your brokerage account every morning” is bad or “Sell every investment you own in a complete panic” is bad?

Investment professionals describe your ability to stick to your financial plan in the face of investment losses as your tolerance for risk. It’s okay to panic when the big red numbers start filling your portfolio page, says Brad Klontz, certified financial planner and professor of financial psychology at Creighton University. But if you let that panic drive you into hasty financial decisions, you’re likely to do real damage to your money, says Klontz.

“Who doesn’t panic? If you’re on a roller coaster that’s going down and your stomach is turning, that’s normal,” he says. The problem arises when it “makes you want to jump off a ride or never ride a rollercoaster again.”

How to take the right amount of risk

If recent market shakes haven’t affected your financial plans, your only next steps are to stay on track. But if you veered from your plans or didn’t have a plan in the first place, it’s time to put your portfolio on the right track.

Start with your ability to take a risk, Benz suggests: “Keep in mind what you are trying to achieve and how close you are to it when you need the money. You may need sub-wallets for different goals.”

In general, younger people who are saving for retirement can often invest that portion of their portfolio in a wide variety of stocks, Benz says. They offer higher long-term returns than other types of assets, but they also tend to come with greater risk.

For short or medium-term goals spanning one to three years, “consider adding safer assets such as cash, short-term bond funds, and US government bond funds,” Benz says. From there, she adds, think about how you will react to losses in the future: “The ability to risk does not matter if you’re going to overturn your well-crafted plan when you don’t feel comfortable with the losses you’ve incurred in a short-term.”

Lots of online surveys can help you determine your risk tolerance. Experts say examining your behavior during the last withdrawal can be an equally useful metric.

“If I don’t feel comfortable in this kind of volatile market, I need to remember that and put safeguards in place so I don’t feel this way the next time it happens,” says Kelly Lavigne, Vice President of Consumer Insights at Allianz Live. “Because it will happen again. You will feel bad again.”

To avoid the kind of panic you might feel in the first half of the year, consider reducing your allocation to riskier assets like stocks and cryptocurrencies. You may also want to consider investing in a fund that will manage the provisions for you.

“An all-in-one box, such as a target date box, can help remove you from the equation and allow the product to do the heavy lifting,” Benz says.

A financial advisor may be able to help on this front, too, says Levine: “The most important thing is to make sure you don’t follow your gut and pull out of the market until you’ve talked to someone who can help you personalize.”

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